Europe faces week of challenges in debt crisis

Sep 5, 2011, 12:11 a.m.

The picture shows the building of the German Federal Constitutional Court Bundesverfassungsgericht in Karlsruhe February 20, 2002. REUTERS/Ralph Orlowski

The ECB's intervention was launched on the understanding that Italy would rush through an austerity plan to regain market confidence. But efforts by Prime Minister Silvio Berlusconi's embattled government to do this have been plagued by disputed figures, policy U-turns and cabinet rows.

Now the ECB will have to decide whether to continue its bond-buying -- or whether the purchases are actually worsening the situation by reducing pressure on Italy to reform its finances. Italian bond yields have started rising back in the past week; some traders think the ECB may deliberately be permitting this in an attempt to obtain leverage over Rome.

The ECB is widely expected to maintain a substantial level of bond-buying in coming weeks because an Italian yield surge could destabilize the whole region. But it may not purchase enough to keep yields at comfortable levels for Italy, especially if the strengthening of the EFSF is delayed and the fund is not able to take over buying in October as hoped.

Meanwhile, Greece has set a deadline of Friday afternoon for European banks to express their interest in its bond swap; the banks will be required to commit by mid-October.

Athens wants 135 billion euros of outstanding bonds to be swapped or rolled over, which translates to a high take-up rate of 90 percent. It has warned that the whole scheme, and conceivably even its plan to receive a second international bailout, could be threatened if that target is not hit.

Greece appears likely to come close enough to the 90 percent threshold to declare the operation a success; the chief executive of Intesa Sanpaolo, Italy's biggest retail bank, said on Saturday he was hearing positive indications from the Institute of International Finance banking lobby group.

But even if the debt swap is fully taken up, analysts think that combined with other planned measures, it will only produce a drop in the ratio of Greece's debt to its gross domestic product to around 120 or 130 percent over the next few years, from above 150 percent now. So another, more painful Greek debt restructuring may be inevitable down the road.

RADICAL STEPS

This helps to explain why markets are unlikely to react with much optimism even if events this week turn out positively -- and why a growing number of past and present policymakers are advocating more radical crisis steps.

"I want to be clear here. The European Union and the euro are strong and resilient. We are doing all it takes," he said on Monday in Australia after talks with Prime Minister Julia Gillard.

Still, Italian Economy Minister Giulio Tremonti repeated his call on Sunday for euro zone governments to issue bonds jointly, saying the measure was vital to resolve the crisis. Germany has strongly resisted the idea on the grounds that it would penalize financially responsible countries.

Former German chancellor Gerhard Schroeder on Sunday called for the creation of a "United States of Europe," saying the bloc needed a common government with a unified budget policy to avoid future economic crises.

Schroeder, a Social Democrat who ran Germany from 1998 to 2005, said European Union member states would have to return to the negotiating table and hammer out a new treaty covering the bloc's institutional framework.

Steen Jakobsen, chief economist at investment bank Saxo Bank, said governments had great political will to protect the euro zone, and were likely to take drastic action eventually to head off disasters such as an Italian exit from the zone.

But for this to happen, he said, "Germany needs to step up to the plate in a way it has not done so far."